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A peril causes covered property damage and business interruption, and also triggers legal obligations to respond to government orders that increase the cost and length of time that would have been required simply to rebuild the property as it was at the time of the peril. This is common when government regulators order (and common sense dictates) that measures be taken to minimize the likelihood that the incident will recur. Whether coverage exists for the increased costs to repair or replace insured property, and for the increased time element losses, is a frequent dispute arising in claims for property damage and business interruption losses.

A federal trial court recently addressed some of these issues in Lion Oil Co. v. National Union Fire Ins. Co .of Pittsburgh, PA., Civ. No. 13-CV-1071 (W.D Ark., El Dorado Div., Sept. 10, 2015). Policyholder Lion Oil Company (“Lion”) owns a refinery in Arkansas which receives oil from a 200-mile long pipeline owned and operated by EMPCo, a subsidiary of ExxonMobil (“EMPCo”). Lion had insurance coverage for “all risk of direct physical loss or damage” to covered property, subject to policy exclusions. The coverage included contingent time element loss “resulting from” damage to property that prevented certain direct suppliers, including EMPCo, from rendering their goods to Lion. The contingent time element deductible was either 30 or 45 days.

On April 28, 2012, the pipeline ruptured. EMPCo shut the pipeline and notified the Department of Transportation Pipeline and Hazardous Material Safety Administration (“PHMSA”), the federal agency responsible for pipeline safety.

On May 8, 2012, PHMSA ordered EMPCo to, among other things, prepare an “integrity verification and remedial work plan,” including: (1) a metallurgical analysis, failure analysis, and an integrated compilation of relevant pipeline system data; (2) field testing to assess whether conditions that caused the failure or other integrity-threatening conditions were present elsewhere in the line; and (3) provisions for long-term testing and verification measures.

By mid-May 2012, within 30 days of the rupture, EMPCo had replaced the ruptured section of the pipeline. EMPCo began the integrity testing required by the government in July 2012, and discovered and repaired seven additional leaks. PHMSA granted permission to restart the pipeline in October 2012. EMPCo then began the work necessary to restart shipments of oil, and Lion began receiving crude oil from the line in March 2013.

Lion submitted a contingent time element claim of $44 million and an extra expense claim of $36 million. Lion’s insurers denied coverage. Lion sued, and the insurers moved for summary judgment.

First, the insurers argued that the interruption of Lion’s business did not “result from” the April 2012 rupture of the pipeline, but rather from EMPCo’s inspection, in compliance with the government order, of the entire pipeline for defects that might cause future ruptures. The insurers argued that the damaged section of the pipeline was fully repaired and capable of conveying oil within the period of the contingent time element deductible.

Lion argued, conversely, that that the contingent time element coverage requires only the occurrence of property damage that, for whatever reason, prevents a named supplier from delivering goods to Lion. In Lion’s view, its losses “resulted from” the rupture, because, but for the rupture, there would have been no shutdown and inspection, and Lion’s loss would not have occurred.

The court denied the insurers’ motion for summary judgment. After holding that the policy language did not expressly limit claims for loss to the length of time necessary to repair the damaged property, the court held that there was a question of fact as to whether the full period of business interruption “resulted from” the rupture. Specifically, applying Arkansas law, the court found a question of fact as to whether the “dominant and efficient cause” of Lion’s loss was the rupture or EMPCo’s inspection of additional line in compliance with the government order.

The insurers gained no traction with their heavy reliance on the decision in MarkWest Hydrocarbon, Inc. v. Liberty Mutual Ins. Co., 558 F.3d 1184 (10th Cir. 2009). In MarkWest , the policyholder owned and operated a pipeline that ruptured. The policyholder replaced the damaged section of pipe within the deductible period for time element coverage, but the government required hydrostatic integrity testing of several miles of additional line. The Tenth Circuit reasoned that “[t]o read the policy as covering MarkWest’s costs of complying with safety regulations would be to convert the parties’ policy against unforeseen fortuities into a maintenance contract.” Id. at 1192. The Lion court distinguished MarkWest on the basis that MarkWest owned the pipeline, whereas Lion did not, and therefore the Tenth Circuit’s concerns regarding the moral hazard of converting an insurance policy into a maintenance contract were not applicable.

Second, the insurers relied on the policy’s exclusion for the “cost of making good” faulty workmanship. The court rejected this argument as a matter of law, noting that the exclusion specifically excepted loss “resulting from” faulty workmanship. The court held that the exception to the exclusion made clear that the “cost of making good” refers only to the specific cost of replacing or repairing damaged property and not to any contingent loss or consequential damages stemming from faulty work.

Third, the insurers relied on the policy’s exclusion for “latent defect,” a contention that the court also rejected as a matter of law. The insurers argued that the seam weld imperfection that caused the rupture was a latent defect; Lion argued that the imperfection was not a latent defect because it was discoverable by a careful inspection, which is the relevant standard under Arkansas law. In fact, the defect that caused the rupture had been detected in a 2007 inspection commissioned by EMPCo, but was mischaracterized by the inspectors as “a manufacturing defect in the seam weld that is unlikely to cause a failure mechanism for the pipeline in the future.” The parties agreed that the inspection was reasonable and state-of-the-art. The court held that the “fact that the test results regarding the anomaly at issue were misinterpreted does not mean that the anomaly was not discoverable.”

The public docket indicates that this case is set for trial in late October 2015. The case bears watching with regard to other important recurring issues identified in the pleadings that the court did not address in the summary judgment opinion.